MILLIMAN WHITE PAPER
Stepping through the
spot rate, alternative pension
expense calculation
Chris Jasperson, FSA, MAAA, EA, CFA
One of the biggest developments in
pension accounting in recent years
has been the trend toward using the
spot rate approach for calculating
pension expense.
Several alternative pension expense approaches exist, but
the spot rate approach is the resounding favorite among plan
sponsors who made the switch—we’ll walk through why it is
growing in popularity.
The spot rate approach uses individual “spot” interest
rates from a corporate bond yield curve rather than a single
average discount rate derived from such a yield curve. The
distinction may sound obscure, but using the spot rate
approach can have a meaningful effect on an employer’s
accounting results. For an upward-sloping yield curve, the
spot rate approach generally lowers the interest cost and
service cost1—and therefore the pension expense—compared
with using a single average discount rate. In addition,
this approach is more refined and applies the yield curve
consistently across all of the calculations required under
U.S. GAAP financial accounting.
Milliman’s most recent annual corporate pension funding
study2 noted that 37 of the 100 largest corporate defined benefit
(DB) pension plans indicated their intention to adopt the
spot rate approach in their most recent Form 10-K reports.
The study’s authors estimate this change will reduce these
companies’ interest cost (IC) about 20%.
Obviously, a 20% reduction in IC can be significant, which
effectively sends a message to sponsors of DB plans of all
types and sizes: Should you consider this strategy for your
pension plans?
1
Because many plans are frozen and do not have a service cost, we focus
most of our attention on the interest cost calculations.
2
Perry, A.H. et al. (April 7, 2016). Milliman 2016 Corporate Pension
Funding Study. Retrieved July 31, 2016, from http://us.milliman.com/
insight/2016/2016-Corporate-Pension-Funding-Study/.
Stepping through the spot rate,
alternative pension expense calculation
A SHORT TIMELINE FOR APPROVAL AND ACCEPTANCE
To help start the discussion, let’s review the recent history of the
spot rate approach. AT&T Inc. was the first mover, disclosing
the change to the new approach in its Form 10-K in late 2014.
In April 2015, the U.S. Securities and Exchange Commission
(SEC) began investigating the change from a compliance
perspective. By September, SEC officials had concluded that
spot rate calculations passed muster, and communicated to
representatives of the Big Four accounting firms that the SEC
would not object to use of the spot rate approach (given certain
facts and circumstances). Before the end of 2015, the American
Academy of Actuaries had also weighed in.
It seems remarkable that 37 of the 100 largest corporate pension
programs could have moved so quickly to adopt the new
approach. But it makes sense when you consider that, according
to the Milliman study, IC savings3 could have exceeded $14
billion in 2016 if all 100 of the largest DB plans had switched to
the spot rate approach.
Without going too deeply into technical details, let’s look at
how the spot rate approach differs from the traditional singleweighted-average approach. This will also demonstrate how the
IC savings are generated.
SIMPLIFIED EXAMPLE
For purposes of illustration, we’re creating a simple pension plan
with three people. At retirement, each will receive a $10,000
lump-sum payment. Presently Joe is 60 years old, Joy is 55, and
Ben is 50—and we’re assuming each will retire at age 65.
When calculating the liability for financial reporting purposes, the
present value of those cash flows must be taken. We’re using the
Above Median Citi Pension Discount Curve from April 30, 2016,
graphed on page 2 (Figure 2). The standard approach solves for a
single equivalent discount rate (SEDR) based on the yield curve
and the plan’s cash flows. The SEDR—rather than the yield curve—
is then used to calculate the projected benefit obligation (PBO), IC,
and service cost (SC). In this example, the SEDR is 3.06%.
3
Eventually, as discussed in the net gains and losses section below, these
savings will be recognized through gain/loss amortization, so the IC
savings is really a deferral of pension expense.
SEPTEMBER 2016
MILLIMAN WHITE PAPER
FIGURE 1: FYE 2015 - PBO CALCULATION
FYE 2015 - PBO CALCULATION
TIME TO RETIREMENT
PBO PAYOUT
YC
PV AT YC
PV AT SEDR
0
0
1.01%
0
0
1
0
1.29%
0
0
2
0
1.47%
0
0
3
0
1.72%
0
0
4
0
1.98%
0
0
JOE: 5 YEARS
10,000
2.19%
8,975
8,600
6
0
2.41%
0
0
7
0
2.54%
0
0
8
0
2.69%
0
0
9
0
2.85%
0
0
JOY: 10 YEARS
10,000
2.99%
7,448
7,395
11
0
3.12%
0
0
12
0
3.24%
0
0
13
0
3.35%
0
0
14
0
3.45%
0
0
BEN: 15 YEARS
10,000
3.54%
5,932
6,360
22,355
22,355
PBO
The total IC is less using the spot rate approach because
lower interest rates are applied to the larger liabilities owed
to employees closest to retirement. By the time the spot rates
are higher than the SEDR, the principal amounts have become
relatively small. You can see this in Figure 2, where the shaded
area below the horizontal SEDR line represents the discounted
liabilities that are due in 10 years or less, compared with the
shaded area above the line, representing the post-10-year liabilities.
PBO IS THE SAME IN BOTH APPROACHES
As you can see in the table in Figure 1, the spot rate approach
applies the interest rates for each year when payouts are
expected: 2.19% in year 5, 2.99% in year 10, and 3.54% in year
15. The standard approach uses the SEDR of 3.06% to discount
each cash flow.
Using the respective spot rates, from either the yield curve or
the SEDR, we obtain the discounted cash flows for each of the
three participants. The sum of discounted cash flows for the
employee population is the PBO.
FIGURE 2: YIELD CURVE AND SEDR
As Figure 1 shows, the PBO is identical for the plan as a whole
using both approaches.
4.5
4.0
3.5
IC IS LOWER USING THE SPOT RATE APPROACH
3.0
The IC using the spot rate approach is lower compared with
the standard approach. Let’s take a closer look.
2.5
2.0
Under the spot rate approach, the IC is the sum of the cash
flows that make up the PBO for each participant multiplied by
the appropriate spot rate. As Figure 3 shows, on page 3, with a
typical upward-sloping yield curve, the IC is smaller for Joe,
who retires in five years; evens out for Joy, at 10 years; and
becomes larger after that for younger employees like Ben, who
will retire in 15 years.
Stepping through the spot rate,
alternative pension expense calculation
1.5
1.0
0.5
0.0
1
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17 18 19 20 21
Yield Curve
2
SEDR
SEPTEMBER 2016
MILLIMAN WHITE PAPER
NET GAINS AND LOSSES
FIGURE 3: INTEREST COST COMPARISON
We encounter another simple mathematical truth when we
calculate the PBO year over year: When the yield curve is upward
sloping, the spot rate approach will always result in either smaller
gains or larger losses relative to the standard approach.
INTEREST COST STANDARD APPROACH
LIABILITY
SEDR
INTEREST COST
JOE
$8,600.00
3.06%
$263.16
JOY
$7,395.00
3.06%
$226.29
BEN
$6,360.00
3.06%
$194.62
TOTAL
That’s because, in the year-end gain/loss calculation, the
expected liability is projected based on the lower IC, so
expected PBO will be lower. No matter what the actual PBO
ends up being, because the expected PBO was lower, the
resulting liability gain will be smaller (or loss larger). This
can lead to larger losses being amortized in later years. Over
time, this will offset the reductions in pension expense that are
produced by the spot rate approach.
$684.07
INTEREST COST SPOT RATE APPROACH
LIABILITY
SPOT RATE
INTEREST COST
JOE
$8,975.00
2.19%
$196.55
JOY
$7,448.00
2.99%
$222.70
BEN
$5,932.00
3.54%
$209.99
TOTAL
This means the pension expense reductions from the spot
rate approach boil down to a question of timing. Eventually,
pension expense will increase as smaller gains and larger losses
are amortized. Thus, in considering this strategy, it’s always a
question of when do you want to recognize pension expense?
Generally, because of the time value of money (which gain/loss
amortization ignores), companies want to recognize pension
expense as slowly as possible.
$629.24
WHAT IF THE YIELD CURVE FLATTENS OR INVERTS?
In this hypothetical example, the spot rate approach reduces
pension expense by about 8%. However, recall that in the
pension funding study, the IC reduction of programs using the
spot rate approach was estimated to be 20%. The shape of the
yield curve and the maturity4 of the plan are the key drivers of
the magnitude of the IC reduction. Briefly, the steeper the curve
or the more mature the plan, the larger the reduction and vice
versa. But what happens if the yield curve were flat or inverted
(downward sloping)?
SPOT RATE APPROACH DEEMED INCOMPATIBLE WITH BONDMATCHING STRATEGIES
Unfortunately, plan sponsors who set their SEDRs using a
bond-matching strategy and were considering adopting the spot
rate approach, received some bad news. On August 2, 2016, SEC
staff met with the representatives of the Big Four accounting
firms. The SEC staff revealed that the SEC would object to a
switch to the spot rate approach made by plan sponsors who
use a bond-matching strategy.
If the yield curve were perfectly flat, then both approaches
would give the same result. And an inverted yield curve would
produce a larger IC than the standard approach. However, these
conditions have been historically infrequent. Thus, we believe
it’s reasonable to expect the spot rate approach will produce
lower IC with occasional, short-lived exceptions.
The specific strategy the SEC expressed concern with was one
where a yield curve was constructed from a plan’s hypothetical
bond portfolio. According to information reported by those firms,
the SEC argued that the spot rates from such a yield curve were
not directly observable, and therefore the proposed strategy would
not meet the requirement under ASC 715-30-35-8 to use the same
interest rates to measure the benefit obligation and interest cost.5
SERVICE COST IS ALSO LOWER
Another component of pension expense affected by the spot
rate approach is the Service Cost (SC). SC is the discounted cost
(present value) of the benefits the employees will earn in the
next year. Like the calculation of PBO, a higher discount rate
results in a smaller SC.
While there may be more to the story, the rationale reported raises
some questions. With only the information reported, we seem to
run into an unintended contradiction. The corporate bond yield
curves used in pension financial accounting calculations are all
engineered through “generally accepted yield curve construction
techniques,” and, as such, none of the associated spot rates are
necessarily observable. This context implies the SEC’s argument
could be made against the spot rate approach for all plans using a
yield curve to set their SEDR—a conclusion it seems clear the SEC
was not trying to reach given prior staff comments.
Returning to Figure 2 on page 2, we note that the bulk of the
SC liabilities accumulate relatively far out on the yield curve.
Thus, the spot rate approach would be applying discount rates
that are, on average, higher than the SEDR. As a result, we get
a lower SC when we switch from using the SEDR to using spot
rates along the yield curve. While the SC is expected to come
down, the decrease is generally not going to be as large as the
IC decrease. SC might be expected to come down 5% to 7% per
an American Academy of Actuaries Issue Brief.
5
4
For simplicity, we’ll use plan maturity as a proxy for the duration of the
plan’s cash flows.
Stepping through the spot rate,
alternative pension expense calculation
3
Deloitte, (August 24, 2016). Financial Reporting Alert 16-2. Retrieved
August 24, 2016, from http://www.iasplus.com/en-us/publications/us/
financial-reporting-alerts/2016/16-2.
SEPTEMBER 2016
MILLIMAN WHITE PAPER
It’s entirely plausible that the nuances of the SEC’s rationale are
missing or were summarized in a way that certain meaning was
lost. As such, in time, we may receive additional clarification
or new information, but for now plan sponsors using bond
matching likely will not receive auditor approval to switch to
the spot rate approach.
PLAN SPONSORS WITH MULTIPLE PLANS THAT CURRENTLY
USE A SINGLE SEDR
Figure 1 on page 2 shows that the PBO for a single plan is the
same whether the spot rate approach or a SEDR is used. What
about plan sponsors with multiple plans that use the same
SEDR for all plans? In this case, the PBO by plan will vary, but
the total PBO for the company, that is, adding up the PBO for all
the plans, will be the same. The PBO by plan will vary because
we’d be applying the yield curve separately to each plan,
producing unique discount rates by plan.
To help see this, consider our three-participant plan. What
if those were three separate plans, one per participant. It’s
clear that the SEDR would still be 3.06% when the three plans
are combined, but individually, under the spot rate approach,
each plan would have a unique SEDR equal to the spot rate
associated with the time until each participant retired.
On average, the spot rate approach gets us back to the same
total PBO on the company’s books, whether we have three
separate plans or one combined plan.
CHANGE OF APPROACH IS A LONG-TERM, PERMANENT DECISION
The accounting argument for switching to the spot rate
approach generally is that plan sponsors expect it to provide
a more precise estimate of pension expense by applying the
yield curve directly in all calculations rather than the SEDR. It
meets the standard of fiduciary prudence based on the SEC’s
evaluation and commitment not to object to its use—bolstered
by its rapid acceptance by nearly 40% of the largest pension
funds and their auditors.
the SEC’s statement that it won’t object to the use of the spot
rate approach and the many recent precedents, you’re not likely
to encounter objections to the basic principle.
However, it’s a good idea to confirm that converting to the spot
rate is a change in accounting estimate rather than in method.
A change in estimate does not require restating results for prior
years as a change in method would.
It’s also important to recognize that the switch to the spot
rate approach is likely a one-way street and should be viewed
as a permanent feature of accounting for pension plans.
The fundamental case for the spot rate approach rests on
its improved precision: By using the yield curve and all the
information it contains, and applying it consistently in all
calculations (PBO, IC, and SC), and for all plans, the results
will be more precise than they’d be using a SEDR. Once you’ve
presented this argument it would be difficult to reverse course
and switch back to the SEDR-based approach.
SHOULD YOU CONSIDER THIS STRATEGY FOR YOUR
PENSION PLANS?6
Because of the spot rate approach’s improved precision, ability
to reduce pension expense, and the combination of a lack of
SEC objection (at least for plan sponsors using a yield curve
approach)7 and general auditor approval, we envision that it
could continue to increase in popularity. As such, if you haven’t
already done so, you may want to start conversations with your
auditors and actuaries to help determine exactly how the new
approach would impact your pension expense—and if the shoe
fits, outline a transition plan for implementation.
6
Remember the opening question? “Consider” is the key word. The spot
rate approach isn’t necessarily appropriate for all plan sponsors. Each plan
sponsor should consider their own circumstances and decide if the spot
rate approach is right for them.
7
Plan sponsors using a bond-matching approach are not likely to receive
approval from their auditor given the most recent SEC staff comments.
In addition to the accounting rationale for the change in approach,
the reduction in pension expense, which we’ve presented above, is
a clear benefit for an organization’s income statement.
CONTACT
That said, it’s still important to include on any due diligence
checklist a detailed discussion with your plan’s auditors. Given
Chris Jasperson
[email protected]
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Stepping through the spot rate,
alternative pension expense calculation
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